Dehomogenizing deflation

The postwar eradication of deflation would count among the Fed’s achievements were deflation always a bad thing. But is it? Many economists appear to assume so. But a contrasting view, supported by a number of recent studies, holds that deflation may be either harmful or benign depending on its underlying cause. Harmful deflation—the sort that goes hand-in-hand with depression—results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply—that is, by general reductions in unit production costs—which allow more goods to be produced from any given quantity of factors and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.

Historically, benign deflation has been the far more common type.

In other words, not all falls in the price level are bad. When prices fall because of improvements in productive technologies, for example, that’s good. That’s the point of growth. That is growth.